Bet On These 5 Low Leverage Stocks To Avoid Debt Traps

In the complex world of investment, understanding the amount of financial leverage a company bears is crucial. With capital being one of the basic factors of production, companies — especially those facing a dearth of resources — need exogenous funds to finance their corporate expenses, run operations smoothly as well as expand the realm of their business.

Among equity and debt, the two most common options used to boost a company's future earnings, the latter is the more popular one. This is perhaps due to the cheap and easy availability of debt over equity financing.

In fact, statistics indicate that the United States, the richest economy in the world, is the biggest borrower. Notably, huge spending on wars, big tax cuts and stimulating economic programs have all added to the nation’s burden over the years. The Congressional Budget Office estimates that federal debt will rise to 92% of the economy’s GDP in 2029 from 78% currently.

Nevertheless, this should not discourage investors from spending on U.S. stocks since debt has been part of the economy since its foundation and yet the country leads others. What investors need to do is choose stocks with caution, thus avoiding the ones that carry high debt loads.

Here comes the significance of leverage, better to say financial leverage, which indicates the degree to which a company utilizes debt to boost its operations and earn escalated profit margins. Usually investors tend to avoid companies bearing a higher degree of financial leverage to avoid falling into debt traps.

The next question is how to measure a company’s degree of financial leverage. To this end, several leverage ratios have been constructed as efficient tools to evaluate a company’s credit level to support prudent equity investments. The most popular among them is the debt-to-equity ratio.

Analyzing Debt/Equity

Debt-to-Equity Ratio = Total Liabilities/Shareholders’ Equity

This metric is a liquidity ratio that indicates the amount of financial risk a company bears. A company with a lower debt-to-equity ratio shows improved solvency for a company.

With the Q3 reporting cycle gaining steam recently, an investor must be looking for solid growth stocks. However, blindly investing in stocks displaying solid earnings growth, without considering their debt level, might not be a wise move. As uncertainty can hit the global equity market any time, it is reasonable to expect that investors will be more attracted to companies with low leverage than high earnings growth.

The Winning Strategy

Considering the aforementioned factors, it is prudent to choose stocks with a low debt-to-equity ratio to ensure steady returns.

However, an investment strategy based solely on the debt-to-equity ratio might not fetch the desired outcome. To choose stocks that have the potential to give you steady returns, we have expanded our screening criteria to include some other factors.

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Here are the other parameters:

Debt/Equity less than X-Industry Median: Stocks that are less leveraged than their industry peers.

Current Price greater than or equal to 10: The stocks must be trading at a minimum of $10 or above.

Average 20-day Volume greater than or equal to 50000: A substantial trading volume ensures that the stock is easily tradable.

Percentage Change in EPS F(0)/F(-1) greater than X-Industry Median: Earnings growth adds to optimism, leading to a stock’s price appreciation.

Zacks Investment Research

Written By: Zacks Investment Research